Can Mispricing Explain the Value Premium?

Abstract

A great deal of empirical research finds that stocks with low market-to-book (MTB) ratios have outperformed stocks with high MTB ratios. Rhodes-Kropf, Robinson, and Viswanathan (RKRV) (2005) separate the MTB ratio into a mispricing component and a growth options component. We investigate the asset pricing implications of this decomposition. We report that RKRV’s mispricing component, but not their growth options component, predicts abnormal returns for up to five years. In addition, using spanning regressions, we find that RKRV’s mispricing component, but not their growth options component, provides incremental information relative to existing asset pricing models. Moreover, after controlling for mispricing, value no longer beats growth, suggesting that RKRV’s measure of mispricing can explain the value premium. In total, our evidence is consistent with a behavioral explanation of the value premium.

Keywords: value premium, mispricing, growth options, return predictability

JEL Classification: G14